Spiritually Bankrupt

Most people come into my office hoping to file Chapter 7 , which is what they think of when they think of bankruptcy.  And most of the time, this is what I’ll do for them (the other options usually being Chapter 13 bankruptcy or, less often and for reasons I’ll go into in a future post, out-of-court debt settlements).   I’ll skip the basics of Chapter 7 here since they’re available elsewhere on the web, and get to the meat of the consultation.

1. You can still file Chapter 7.  The 2005 amendments to the Bankruptcy Code made it more complicated and more expensive to file Chapter 7, but they did not take away your right to file it.  Most people “pass” the means test, either because their income is lower than the median or because certain expenses (mortgage, medical, child care, taxes, etc.) are higher.  If your debt is due to your business (such as personally guaranteed business credit cards) or taxes, and these debts exceed the amount of your mortgage (or if you rent), you may be eligible to file a “business case” and not take the means test at all.  In other words, in that case, it doesn’t matter how much money you make.

2. The official title of Chapter 7 is “Liquidation” – so what exactly is liquidated?  The upshot for the typical Texas bankruptcy filer is that you won’t lose much of anything.  The technical answer depends on the state you file in and whether you’ve lived there for 2 years yet.  If you’ve lived in Texas for more than 2 years, you get to take the very generous Texas exemptions or the also generous but different federal exemptions.  The Texas exemptions allow you to – generally – keep your homestead no matter the amount of equity, as well as your home furnishings, vehicles, jewelry, and work tools, but no cash, business equity, or investments.  The federal exemptions limit the amount of homestead equity you can exempt, but might allow you to exempt cash, business equity, or investments.  If you haven’t lived in Texas for 2 years, you would need to take the exemptions of one of the states where you previously resided, and most of those exemptions are not nearly as generous.

3. Income taxes are dischargeable under certain circumstances.  Hearing that alone makes clients sigh with relief.  The basics are that the taxes had to be due more than 3 years prior to filing bankruptcy; you had to have actually filed your taxes 2 years prior to filing bankruptcy; the taxes had to be assessed by the tax authority more than 240 days prior to filing; and you had to have not committed any kind of fraud or crimes relating to the filing.  The rules apply to state income tax authorities (not usually an issue in Texas unless you moved from another state) as well as the IRS, and only apply to income tax (e.g. 1040), not to other kinds of taxes such as employee withholding (e.g. 941).

4. Some debts are nondischargeable, and some transactions can lead to problems for other people besides you.  Most taxes, child support, alimony, divorce property settlements, debts incurred by fraud, and other kinds of debts can’t be discharged in bankruptcy.  Student loans can be discharged, but it’s very difficult – you have to file a separate lawsuit in the bankruptcy and have to show that you really can never pay them back.  Also, if you give away property or sell it for less than it’s worth, a bankruptcy trustee can sue the person you transferred it to and distribute the proceeds of the lawsuit to your creditors.  The trustee can also sue a creditor (including a family member!) whom you recently repaid.

5. Effects of bankruptcy: The effects on your credit are not nearly what they’re made out to be in the media.  Though Chapter 7 is listed on your credit record for 10 years, it doesn’t affect your score for that long.  Mortgage bankers and former clients have both told me that your credit recovers in about 2 years as long as you do the right things – reaffirm some debts and/or get new accounts after bankruptcy, and pay timely every month.  It’s not rocket science to figure out why this happens – you just filed bankruptcy so you can’t file again for 8 years; you (probably) have an income; you have no other debt.  If I am a lender, you look better to me than most Americans, who have debt and can file bankruptcy to discharge my loan to them at any time.  You are actually more likely to pay me back.  One caveat – among many – is that I’ve been told that you won’t qualify for a government-backed mortgage for 4 years now, up from 3 before the mortgage crisis.

The other effect clients ask about is in hiring.  It is against the law for an employer to discriminate against you for filing bankruptcy, and I have heard from HR people that as long as you are not applying for a senior or sensitive position, it won’t be an issue as long as you disclose it if asked.  The main thing is to have a sympathetic story to tell the employer – that your bankruptcy was caused by a business failure, or illness, or layoff, or divorce (these are the reasons why most people file anyway); or at the very least be able to talk about what you learned from the experience of filing.  There are still some people out there who may not listen to your reasons and just cross you off the list, but honestly you did not want to work for those people anyway!

The bottom line is that Chapter 7 is usually the quickest, least expensive, and most comprehensive way to deal with debt.  In a future post, I will talk about the alternatives to bankruptcy and give the pros and cons of each.